There is no greater darling stock on the ASX than Cochlear, the fabulous Australian success story which has brought hearing to more than 250,000 profoundly deaf people globally through the bionic ear technology which was developed by Professor Graeme Clark at Melbourne University in the 1970s.
And for investors who paid just $2.50 a share when the panic-stricken Pacific Dunlop floated the business in 1994, Cochlear has been a magnificent investment, jumping another 50c to $72.32 in morning trade today.
But having a feel-good story that delivers for shareholders doesn’t mean the basics around executive pay, good corporate governance and disclosure should be ignored.
And so it was yesterday with the shareholder revolt against Cochlear’s remuneration report and the proposal to issue long-serving CEO, Dr Chris Roberts, 231,161 options to buy shares at $62.78 a pop in August 2015.
At the 2010 Cochlear AGM, shareholders overwhelmingly approved Dr Roberts being issued 86,272 options to buy shares at $69.69. If all hurdles are satisfied, he’ll pay $6 million to exercise these options in August next year. At the 2011 AGM, there were no complaints about Dr Roberts being issued 117,620 three-year options over shares at $68.56. If all hurdles are satisfied, he’ll pay $8 million to exercise these options in August 2014.
Seeing as the formula for the annual allocation was pretty much the same — that Dr Roberts is entitled to an options grant valued at 75% of his fixed pay — the obvious question to ask was why was the 2012 allocation so much larger than the previous two years?
Never before had the annual options play being so big, as it will require a hefty cheque of $14.5 million if Dr Roberts takes up the shares in August 2015. It didn’t help the board that Cochlear shares had rallied in the weeks after the options were priced, because it never looks good to be issuing a CEO options which are already “in the money”. This is especially so when you have a CEO who has already ridden this long-standing options play to a lucrative position of owning 715,803 fully paid ordinary shares which are today worth $51.7 million.
This is a greater equity position than any other non-founder CEO in the ASX50, including Nicholas Moore at Macquarie Group and Marius Kloppers at BHP-Billiton, who both own about $40 million worth of ordinary shares.
The obvious defence against claims that Dr Roberts was about to get options which were already $2 million “in-the-money”, would be to look at the strict performance hurdles which are put in place. And this is where Cochlear ran into trouble. Because the one-off product recall smashed 2011-12 earnings, it created a very low base for the “Earnings Per Share” hurdle. Indeed, underlying EPS would have to fall by more than 37% by 2015 for Dr Roberts not to satisfy this particular hurdle, which applied to 50% of the allocation. The other half has a hurdle based around total shareholder returns which is genuinely challenging.
That ridiculously low EPS hurdle may have been defensible if Cochlear was only issuing 100,000 options, but this is where the real controversy kicks in. Under the controversial Black-Scholes pricing formula, you have to make a series of assumptions to come up with the value of each option. Under his contract, Dr Roberts was entitled to options worth $1.02 million based on the expense they would be likely to incur. Cochlear determined an option to buy a share at $62.78 in August 2015 would be expensed next 30 June at $4.44 now. That’s how the figure of 231,161 options was arrived at. It’s $1.02 million divided by $4.44.
When pricing these options, you discount the valuation based on a series of probabilities and volatilities. The notice of meeting didn’t explain why Dr Roberts was being issued so many more options than the previous 2 years.
What happened next was the Australian Council of Superannuation Investors and its advisers alerted institutional investors about the issue. Many were angry.
It turns out that Cochlear’s management came up with a proposed 33% discount on the option valuation for the risk of not meeting the EPS hurdle. But surely that ridiculously low EPS hurdle of -37% was unmissable because of the recall. Another 22% discount on the valuation was applied because of the risk that Dr Roberts wouldn’t be in the job. Who came up with these figures?
Whilst KPMG may have looked at the inputs into this formula and signed off on them, the inputs themselves were supplied by the company and not changed by KPMG, which also happens to be Cochlear’s auditor. Seeing as the scheme applies to the wider Cochlear management team, they are all set to benefit from bigger than usual options plays. Only the CEO had to run the gauntlet of shareholder approval.
The key lesson from this saga is that the board’s remuneration committee should have commissioned a genuinely independent valuation of the options. When all of this was pointed out to Cochlear chairman Rick Holliday-Smith, he had two choices: withdraw the proposal or try and bluff and bluster his way through. He opted for the latter with his institutional shareholders by playing an aggressive lobbying game in which he claimed an “against” vote represented a vote of no confidence in the CEO. This saved the options from being defeated but didn’t stop a first strike on the remuneration report.
Holliday-Smith is also chairman of the ASX and the Cochlear meeting was held in the ASX Theatrette on Bridge St. Yesterday’s one hour debate on all this remuneration issues was one of the best examples in years as to why the AGM is an important event. All the key information was disclosed in public during the course of the meeting and the management team had to sit there squirming whilst the full board looked silly.
*Stephen Mayne is policy and engagement co-ordinator with the Australian Shareholders’ Association which voted almost $20 million worth of stock against both pay resolutions yesterday